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Commercial Question

Green bonds: part of an economic revolution?

updated on 23 October 2018

Question

How can private investment and global capital markets have a role in tackling climate change?

Answer

On 8 October 2018, the United Nations’ Intergovernmental Panel on Climate Change released a report saying that the world must urgently change the global economy in order to avoid ecological disaster. It is estimated that around $90 trillion of ‘green’ investment is needed by 2030. This is a huge amount and one that cannot be met by central government spending alone. Private investment and global capital markets will be required to play a pivotal role in any such economic revolution.

The international capital markets already have a measure that can play a substantial role – the ‘green bond’.

What is a green bond?

A green bond is a debt instrument that may be issued by a company, financial institution or sovereign nation, the same as any regular bond. It represents an obligation to pay the bondholder the principal amount of debt at the end, or ‘maturity’, of the bond’s term and the bond’s specified interest rate. However, a green bond is different in that the issuer must ensure that any proceeds raised go toward a green project, such as sustainable living, renewable energy, wastewater reclamation or production of zero-emission vehicles. The issuer can raise finance for its needs and the bondholder is able to generate a fixed income from the interest on the bonds. Both parties are able to display themselves as contributing toward environmental goals and sustainable ventures.

The European Investment Bank issued the first green bond in 2007 as part of an initiative to raise awareness regarding climate change. The issuance was very small and things have changed dramatically since then. Sovereign governments such as France and Poland are now issuing these bonds, along with some of the largest companies in the world, including the technology giant Apple. As of mid-October 2018, over $100 billion in green bonds had been issued for the year. Ireland issued its first such bond, raising over €3 billion at the beginning of October 2018 and receiving €12 billion worth of orders from the market. There is now substantial appetite across the world for this type of investment.

How green is it?

However, despite the lofty ideals surrounding the conception of the green bond and its growing prevalence in international debt markets, there is significant scepticism from some corners. Certain parties view the green bond as a simple ‘green-washing’ of the proceeds raised and a misrepresentation of how environmentally friendly the bond issuer or stated project is. There is currently little in the way of overarching regulation that can hold issuers to account. For example, while Indonesia raised $1.25 billion from its green bond issue in February 2018, commentators have pointed to Indonesia’s involvement in the palm oil industry and a rapid deforestation programme. Many have stated that these activities are too antithetical to the concept of environmental sustainability for the government to lay claim to any ‘green’ credentials.

What is clear is that the market remains relatively new, is evolving quickly and has far less oversight and regulation than the traditional bond market. There have been calls for greater regulation of the market, impact reporting from issuers and for clearer lines to be drawn so that it can be more easily determined what is ‘green’ and what is not. Investors want to know that what they are buying into is a green venture. Issuers of the bonds would also benefit from having a clearer understanding of what they can and cannot do and so what might constitute a default under the terms of the bond documentation.

This uncertainty is hindering the market from growing as quickly as it might. Certain would-be issuers are choosing not to raise money through issuing green bonds, as they are fearful that if they do, an enterprising investor may purchase the bonds and then call a default under the bonds’ documentation due to the issuer having acted in a certain way that is not ‘green’ and not compliant with the bonds’ documents.

Is this uncertainty being addressed and what is being done to grow the market?

While governments have stated that they will place greater legislative emphasis and governmental priority on climate change, little in respect of environmental financial law has so far been codified. Much of the law surrounding this asset class has yet to be written.

But this is changing.

In March 2018, the EU Commission began drafting various pieces of legislation related to sustainable finance governance. These items will cover the creation of a unified taxonomy regarding what is ‘sustainable activity’, the levels of disclosure that the issuer must meet regarding environmental, social and governance factors in their risk processes and a new category of benchmarks. These benchmarks will comprise ‘low-carbon’ and ‘positive carbon’ impact benchmarks, giving investors clearer information on the carbon footprint of their investments.

The UK government’s green finance taskforce issued a report in early 2018. This report contained a number of recommendations for the government, including that it issue its own green sovereign bond to rival France’s previous €10 billion issue and that it establish a number of green financial institutes to conduct research into the growth of sustainable finance.

With 59 green bonds listed on the London Stock Exchange as of December 2017, the UK has credibility in the field. The extent to which the UK will continue to be one of the leaders in this area will depend on the prioritisation that sustainable finance is given by the current and future UK governments.

What is the future of the market?

There is great and growing sentiment among the world’s investors for green projects. University endowments, family offices and investment funds are withdrawing their support and capital from fossil fuel-related assets and investments. However, their need for income will remain and green bonds represent an investment into which they can place their money and generate a much-needed financial return in line with their changing investment criteria.

The regulatory environment for green bonds will continue to develop at an accelerating pace in markets across the world. As governments place a greater emphasis on sustainable finance going forward and sustainable technology improves too, giving investors new green investment opportunities, supply and demand of and for green bonds will increase. It remains to be seen which regulators, markets and governments will take best advantage of this fast growing and increasingly vital new branch of finance.

Fergus Langstaff is a trainee solicitor at White & Case.